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June 20, 2012

The Logic of Eurobonds

Ever wonder why our nation’s capital is wedged between Virginia and Maryland? The answer is known as the Compromise of 1790. While the North struggled with over $54 million in debt, the Southern states—and in particular those mentioned above—enjoyed a large surplus. So in order for the federal government to assume this debt, which would move from the Northern state’s balance sheets to that of the United States, Alexander Hamilton and Thomas Jefferson agreed to allow the South to keep some influence over the capital by placing it under the Mason-Dixon line.

This mini history lesson is of course an analogy for what’s happening to Europe. Like the United States in 1790, the Continent uses a common currency, but has yet to come together as a formal economic union. The EU must decide if it wishes to formalize the relationship or it will lose its peripheral countries. Logic dictates that the final decision will be the one deemed the least onerous, which points to the creation of eurobonds.

In theory, eurobonds would work similarly to a conventional bond, allowing all 17 eurozone member states to assume responsibility of a debt rather than one country in particular. This would allow for countries such as Spain, which borrows at a high interest rate, to afford lower borrowing costs and repair its fractured banking system.

While some countries urge for the formation of a eurobond system, others are less enthusiastic about the idea. Germany, which borrows at a very low rate thanks to its robust economy, seems resolute in its opposition. Chancellor Merkel has stated that eurobonds would only perpetuate Europe’s financial issues, as financing growth through more debt will only delay another economic crisis. Other European leaders believe that the cheap borrowing costs of eurobonds may promote irresponsible spending on the part of struggling countries.

Some economists feel that eurobonds would weaken Europe’s stronger economies such as Germany and Norway without benefitting struggling countries in the long run. They believe that they should not have to pay for the irresponsibility of other member countries.

Still, other eurobond solutions have been proposed. Germany’s economic advisory group, also known as the “Wise Men”, have suggested that countries with debt above 60% of GDP (such as Greece) would be able to issue the debt during a 25-year period. Conversely, an idea known as “blue bonds” has also been suggested. This plan would allow for countries with under a 60% debt/GDP ratio to have legitimate eurobonds, which allows for safer investing. Countries with over a 60% debt would not have liable eurobond backing, and thus debts would have to be paid through national means. Obviously, this blue blood concept would do nothing to immediately improve the issues facing Southern Europe.

I’m no student of history, but I bet these types of ideas were as widely discussed in 1790 as they are today. The bottom line is that, unless there is a compromise, the EU will fall apart. I think that is unacceptable to its members, who know that Europe will simply not be as competitive without more cooperation. The next EU summit is June 28-29, so stay tuned.

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